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Preferential tax treatment and the flexibility to restructure investment allocations in estate planning are two concepts that simply do not mix well when it comes to investing in life insurance.
A recent IRS private letter ruling could help change that forever by easing financial producers’ headaches over the transfer for value rule—a tax trap that can cause typically tax-favored life insurance policies to become subject to taxation. The IRS ruling provides clear guidance to help clients transfer life insurance policies for consideration without falling prey to the transfer-for-value rule so that tax-favored life insurance policies can be transferred within a related portfolio without becoming subject to taxation.
Basics of the Transfer for Value Rule
Even the savviest clients can run afoul of the transfer-for-value rule, considering its myriad exceptions and caveats. Essentially, if a taxpayer transfers an interest in life insurance for anything of value, the usual exclusion from gross income is limited to an amount equal to the sum of (1) the value of the consideration and (2) any premiums paid by the person obtaining the policy.
The results can cause the loss of substantial tax benefits. If a policyholder transfers a $5 million policy on his or her life for $500,000, and the transferee later pays premiums totaling $100,000 before the insured dies, only $600,000 of the death proceeds will be excludable from gross income. If the policyholder had not made the transfer, the entire $5 million would be excluded.
Certain related parties, including the policyholder’s parents and children, are excluded from the rule and can receive transfers without triggering such adverse tax results. Transfers in which the transferor’s basis is carried over to the transferee for purposes of determining gain or loss, and transfers to the insured himself, are also excepted from the rule.
The Facts of the Matter
The matter before the IRS involved two trusts, both of which involved the taxpayer. The first trust benefitted the taxpayer himself (Trust A), while the second trust was established by the taxpayer (and grantor of the trust) for the benefit of his children and grandchildren (Trust B).
While both trusts were irrevocable, the taxpayer retained the power to reacquire assets he had placed within Trust B by substituting assets of equal value. The independent trustee responsible for overseeing Trust B was required to ensure that any substituted assets were of equal value to the assets the taxpayer chose to reacquire.
Trust A owned a life insurance policy on the taxpayer’s life, which the taxpayer wished to transfer into Trust B using his power of substitution. The taxpayer petitioned the IRS for advice as to whether the contemplated transaction would cause adverse tax consequences.
The IRS found that the transaction would not trigger unfavorable tax consequences because it fell within an exception to the transfer-for-value rule. Because the taxpayer was both grantor of Trust B and the insured individual under the policy, the transaction was considered a transfer of the policy to the insured himself. This result is due to the treatment of grantor trusts—the grantor and the trust are treated as a single entity for tax purposes.
Therefore, even though the transfer was technically a transfer of the policy from one trust to another, it was considered to fall within the exception to the transfer for value rule permitting transfers to the insured himself.
Further, the value of the policy would not be included in the taxpayer’s gross estate for estate tax purposes even though the taxpayer retained the right to move the policy between two irrevocable trusts. Typically, this type of power over an asset could cause the courts to find that a taxpayer retained incidents of ownership in an asset sufficient to warrant the asset’s inclusion in the estate.
In this case, however, the taxpayer could never reduce the value of the assets in Trust B because he was required to substitute assets of equal value—and an independent trustee was present to verify equivalence. Additionally, the taxpayer could not increase his own net worth through a transfer because, again, the values were required to be equal.
The IRS may not have clarified all of the potential traps posed by the transfer-for value-rule, but its recent private letter ruling goes a long way toward allowing taxpayers a greater degree of flexibility, while maintaining the certainty of favorable tax treatment in life insurance policy transfers.
Please visit another of The National Underwriter Company’s expert authors, Michael Kitces, MSFS, CFP®, CLU, ChFC, at FPA Experience 2012. Michael (also a regular AdvisorOne blogger) will be presenting on “Understanding the New Medicare Taxes” as well as signing copies of his new book,The Advisor’s Guide to Annuities, 3rd edition, published for 2012 by The National Underwriter Company.
For additional coverage of this issue and similar ones, we invite you to sign up with AdvisorOne’s Summit Business Media partner, National Underwriter Advanced Markets, for a free trial.